Embracing Employee Stock Ownership
Is an ESOP right for your business?
August 18, 2014
Walk through the neat and efficiently laid-out factory near Westfield Southcenter mall, where Red Dot Corporation manufactures heating and air conditioning systems for heavy vehicles, and you may notice, hanging from the ceiling, a giant copy of a check for $640,000.
The original check was presented to an employee to buy back Red Dot shares he had received as part of the companys Employee Stock Ownership Plan (ESOP) during his 25 years of service. And its not that unusual. This year, Red Dot will spend nearly $4 million to buy back shares from retiring employees.
Red Dot is one of thousands of businesses across the country that have turned to tax-advantaged ESOPs to finance expansion, allow owners to cash out and align the interests of employees with the company. According to the National Center for Employee Ownership, 7,000 firms have ESOPs covering 13.5 million employees.
Many high-profile Washington state companies have adopted ESOPs over the years. The 128-year-old Seattle-based general contractor Lease Crutcher Lewis created an ESOP in 2008 as a way of maintaining local ownership. This year, Point B, a Seattle management consulting firm, completed a five-year, tax-efficient process to transfer 100 percent of ownership to its 500 employees. Schweitzer Engineering Laboratories in Pullman, with 3,660 employees, is one of the 100 largest ESOPs in the country.
Employee stock ownership plans were once popular primarily among privately held manufacturing companies. But these days, more service businesses and consulting, architecture and engineering firms are selling to their workers, says Philip Carstens, a corporate and tax attorney with K&L Gates specializing in employee stock ownership plans.
Tim Jenkins, cofounder of Point B, says the ESOP has made his firm more competitive by getting employee owners personally invested in the growth and health of the business over the long term. Jenkins expects many more talent-intensive companies to move to employee ownership to boost their competitiveness.
Companies create ESOPs for lots of reasons. Carstens says many company owners turned to ESOPs in 2010 and 2011 to avoid higher capital gains taxes that were expected to result from the federal fiscal cliff crisis. In the case of Harcourt Harky Runnings, who founded Red Dot Corporation in 1965, it had a lot to do with creating the family he never had as a child.
Runnings mother died while he was a young boy and he was sent to live with relatives on a remote farm in Canada, where he slept in an attic and spent his days doing farm work. In 1922, at age 10, he reunited with his father in Seattle, but since he didnt get along with his stepmother, he was sent to work as a live-in houseboy for a family in West Seattle.
When Runnings launched Red Dot, he treated his employees as his family. He paid them time and a half for vacation and, in the 1970s, adopted a four-day work week. On his retirement in 2000, he spent $2.7 million to pay his 250 employees $1,000 for every year they had been at the company. Then he created an ESOP and transferred ownership to his employees at the lowest price the Internal Revenue Service would allow.
He had a very soft spot in his heart for people, the struggles they faced and the support they needed, says Randy Gardiner, who is Runnings grandson and the current CEO of Red Dot. By all accounts, the arrangement has helped the company thrive. Red Dot has 400 employees and expects revenues in 2014 of $110 million. Its share price has soared to about $78 today from $22 more than a decade ago.
Studies suggest companies with ESOPs perform better over the long term than firms that go through other ownership transitions. A Georgetown University/McDonough School of Business study found that businesses owned by employees through ESOPs performed better than others and did a better job of providing for their employees retirement. In 2008, while overall private employment in the United States fell by 2.8 percent, the rate in surveyed companies rose by nearly 2 percent. Meanwhile, wages grew by 5.9 percent compared to half that amount for the labor force as a whole.
The Employee Ownership Foundation, which promotes employee ownership, says its surveys consistently show companies with ESOPS perform better while employees with stock ownership tend to have more sustainable employment.
ESOPs can be misused. A group of workers at Ohio-based Fifth Third Bancorp recently sued their employer when the companys stock, in which they were invested, dropped 74 percent after the bank got involved in subprime mortgage lending without notifying employees of the increased risks involved. In another case, real estate magnate Sam Zell engineered a leveraged buyout of the Tribune Company in 2007 by creating an ESOP and using employee pension money and new debt to acquire the company on behalf of employees. All contributions to employee retirement plans thereafter were made in stock, which was nearly worthless when the company went bankrupt a year later. Tribune employees later won a $32 million settlement from GreatBanc Trust, trustee for the ESOP.
The first esop was established by Louis Kelso, a political economist who argued in The Capitalist Manifesto in 1958 that, while technology makes factories more productive, workers seldom enjoy the fruits of that increased productivity. Kelso saw the ESOP as a way of democratizing capital ownership in a market economy so that workers would have more purchasing power, which, in turn, would stimulate the economy. Kelso used the ESOP structure to help a closely held newspaper chain buy out its retiring owners.
At Red Dot, CEO Gardiner has maintained the employee-oriented culture his grandfather created. The company still runs on a four-day week, with Fridays reserved for overtime work in some sections. Time-and-a-half pay during vacation, however, was eliminated during the Great Recession.
Employees receive annual grants of stock equal to between 5 and 7 percent of their wages in addition to having a traditional 401(k) plan. Their shares are fully vested after six years. Employees can sell them when they leave the company. If they remain with the company, they have the option of selling 25 percent of the shares at age 55 and 50 percent at age 60. Gardiner says the program helps reduce turnover at a time when it is difficult to recruit manufacturing workers.
Gardiner adds that managing an employee-owned company has its challenges. When employees leave, Red Dot must buy back their shares. A few years ago, when many of Red Dots long-term employees decided to take early retirement at the same time, several payouts were in the seven-figure range, forcing the company to borrow money to cash out the employees. Since then, Red Dot has decided to buy back shares of retirees over a four-year period. (The federal Employee Retirement Income Security Act allows payouts over 10 years.)
This year, Gardiner says Red Dot will pay $3.8 million to repurchase shares from retiring employees. Most received those shares in 2000 when they were worth $22 apiece. Shares are now worth $78 as determined by an outside consultant. With an ESOP, Gardiner admits, you are selling a little bit of the farm every year, which takes gas out of the tank.
But overall, Gardiner notes employee ownership has been a positive force for engaging workers. During a down cycle in 2008, for example, an employee suggested saving energy by turning off the lights in areas where workers were not at their stations. Employee ownership has also encouraged Gardiner to create a culture of transparency. He posts detailed financial statements so that employees can see how the company is performing.
It demystifies the business, he says. You build a lot of trust with transparency.
The Power of the ESOP
A 2000 Rutgers University study found that ESOP companies grow about 2.3 percent faster than other businesses. Other studies cited by the National Center for Employee Ownership conclude that companies pairing an ESOP with employee participation in management grow as much as 11 percent faster than equivalent companies. Studies have also found that ESOP participants make 5 to 12 percent more in wages and have almost three times the retirement assets as workers in comparable non-ESOP settings. According to government filings in 2008, the average ESOP participant receives about $4,443 a year in company contributions and has an account balance of $55,836. More than half of the companies have an additional retirement plan such as a 401(k).
How an ESOP Works
Over the years, Congress has tweaked tax laws to make an Employee Stock Ownership Plan a more appealing alternative. To establish an ESOP in the United States, a firm sets up a trust that oversees the plan. As in a leveraged buyout, the company typically takes out a loan to pay off the owner. The company pays off the loan by making tax-deductible contributions to the plan each year. Employees receive their shares over time as the loan is paid off by the company. Owners who sell to the ESOP can defer taxes on their proceeds by reinvesting in other securities. If a company is owned entirely by an ESOP, it pays no federal income tax. Instead, profits distributed to employee owners, typically when they retire, are taxed at that time or can be rolled into an IRA.
ESOPs in Washington
These companies are members of the Northwest chapter of
The ESOP Association. It is not a complete list of Washington companies operating ESOPs, but offers insight into the broad reach of the employee ownership practice.
Anvil Corporation, Bellingham
Bates Drug, Spokane
Buse Timber & Sales, Everett
Custom Interface, Bingen
EmpRes Healthcare, Vancouver
Harris Group, Seattle
Healthcare Resource Group, Spokane
Landau Associates, Edmonds
Lease Crutcher Lewis Company, Seattle
Lloyd Enterprises, Federal Way
Manhasset Specialty Company, Yakima
Manson Construction Company, Seattle
Meier Architecture Engineering, Kennewick
Pacific Vascular, Bothell
Paine Electronics, Wenatchee
Parts Wholesalers, Spokane
PLEXSYS Interface Products, Camas
Point B, Seattle
Riverview Community Bank, Vancouver
Seattle Gymnastics Academy, Seattle
Sleep Train, Kent
SoundEarth Strategies, Seattle
Stoneway Electric Supply, Spokane
TRS Group, Longview
Leslie Helm contributed reporting to this story.